capital structure basics

8/7/2019 capital structure basics

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Capital StructureCapital Structure

Decisions: The BasicsDecisions: The BasicsCapital structure theory

Overview of capital structure effects

Business versus financial risk

The effect of debt on returns


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Capital Structure Theory MM theory

Zero taxes

Corporate taxes Corporate and personal taxes

Trade-off theory

Signaling theory

Debt financing as a managerial constraint


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MM Theory: Zero Taxes MM prove, under a very restrictive set of

assumptions, that a businesss value is

unaffected by its financing mix: VL = VU Therefore, capital structure is irrelevant.

Any increase in ROE resulting fromfinancial leverage is exactly offsetby the

increase in risk (i.e., rs), so WACC isconstant.


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MM Theory: Corporate Taxes Corporate tax laws favor debt financing

over equity financing.

With corporate taxes, the benefits offinancial leverage exceed the risks: MoreEBIT goes to investors and less to taxeswhen leverage is used.

MM show that: VL = VU + TD. If T=40%, then every dollar of debt adds

40 cents of extra value to business.


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Value of business, V

0Debt

VL

VU

MM relationship between value and debt

when corporate taxes are considered.

Under MM with corporate taxes, the businesssvalue increases continuously as more and moredebt is used.

TD


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Cost ofCapital (%)

0 20 40 60 80 100 Debt/ValueRatio (%)

MM relationship between capital costs and leverage

when corporate taxes are considered.

rs

WACC

rd(1 - T)


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Millers Theory: Corporate andPersonal Taxes

Personal taxes lessen the advantageof corporate debt:

Corporate taxes favor debt financingsince corporations can deduct interestexpenses.

Personal taxes favor equity financing,since no gain is reported until stock issold, and long-term gains are taxed at alower rate.


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Millers Model with Corporate and

Personal Taxes

VL = VU + [1 - ]D.Tc = corporate tax rate.Td = personal tax rate on debt income.

Ts = personal tax rate on stock income.

(1 - Tc)(1 - Ts)

(1 - Td)


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Tc = 40%, Td = 30%, and Ts = 12%.

VL

= VU

+

[1 -

]D

= VU + (1 - 0.75)D

=VU + 0.25D.

Value rises with debt; each $1 increasein debt raises Ls value by $0.25.

(1 - 0.40)(1 - 0.12)

(1 - 0.30)


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Conclusions with Personal Taxes Use of debt financing remains

advantageous, but benefits are less thanunder only corporate taxes.

businesses should still use 100% debt.

Note: However, Miller argued that inequilibrium, the tax rates of marginal

investors would adjust until there was noadvantage to debt.


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Trade-off Theory MM theory ignores bankruptcy (financial

distress) costs, which increase as moreleverage is used.

At low leverage levels, tax benefitsoutweigh bankruptcy costs.

At high levels, bankruptcy costs outweightax benefits.

An optimal capital structure exists thatbalances these costs and benefits.


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Signaling Theory MM assumed that investors and managers

have the same information.

But, managers often have betterinformation. Thus, they would: Sell stock if stock is overvalued.

Sell bonds if stock is undervalued.

Investors understand this, so view newstock sales as a negative signal.

Implications for managers?


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Debt Financing and Agency Costs One agency problemis that

managers can use corporate funds

for non-value maximizing purposes. The use of financial leverage:

Bonds free cash flow.

Forces discipline on managers to avoid

perks and non-value addingacquisitions.

(More...)


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A second agency problemis thepotential for underinvestment.

Debt increases risk of financialdistress.

Therefore, managers may avoid riskyprojects even if they have positive

NPVs.

Debt Financing and Agency Costs


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How could capital structure

affect value?

=+=

1t

tt

)WACC1(

FCF

V

(Continued)

WACC = wd (1-T) rd + we rs


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Consequently

The effect of capital structure onvalue would depends upon the

effect of debt on: WACC

FCF

(Continued)


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The Effect of Additional Debt on

WACC Debtholders have a prior claim on cash

flows relative to stockholders. Debtholders fixed claim increases risk of

stockholders residual claim. Cost of stock, rs, goes up.

businesss can deduct interest expenses. Reduces the taxes paid

Frees up more cash for payments to investors Reduces after-tax cost of debt

(Continued)


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Debt increases risk of bankruptcy

Causes pre-tax cost of debt, rd, to

increase

Adding debt increase percent of

business financed with low-cost

debt (wd) and decreases percentfinanced with high-cost equity (we)

Net effect on WACC = uncertain.(Continued)

The Effect of Additional Debt on

WACC


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The Effect of Additional Debt on FCF

Additional debt increases theprobability of bankruptcy.

Direct costs: Legal fees, fire sales,etc.

Indirect costs: Lost customers,reduction in productivity of managersand line workers, reduction in credit(i.e., accounts payable) offered bysuppliers

(Continued)


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effect of indirect costs

NOPAT goes down due to lostcustomers and drop in productivity

Investment in capital goes up due toincrease in net operating workingcapital (accounts payable goes up assuppliers tighten credit).

(Continued)

The Effect of Additional Debt on FCF


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nUncertainty about future pre-taxoperatingincome (EBIT).

nNote that business risk focuses onoperating income, so it ignores financing

effects.

What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk


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Factors That Influence

Business Risk

Uncertainty aboutdemand (unit sales).

Uncertainty aboutoutput prices. Uncertainty aboutinput costs.

Product and other types ofliability.

Degree ofoperating leverage (DOL).


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Business Risk versus Financial Risk Business risk:

Uncertainty in future EBIT. Depends on business factors such as

competition, operating leverage, etc. Financial risk:

Additional business risk concentrated oncommon stockholders when financialleverage is used.

Depends on the amount of debt and preferredstock financing.


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Business U Business L

No debt $10,000 of 12%

debt$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate

Consider Two Hypothetical

Businesses

Both businesses have same operatingleverage, business risk, and EBIT of$3,000. They differ only with respect touse of debt.


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Effect of Financial Leverage on

Returns

EBIT $3,000 $3,000Interest 0 1,200EBT $3,000 $1,800Taxes (40%) 1 ,200 720

NI $1,800 $1,080

ROE 9.0% 10.8%

business U business L


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Why does leveraging increase return?

More EBIT goes to investors in businessL.

Total dollars paid to investors: U: NI = $1,800.

L: NI + Int = $1,080 + $1,200 = $2,280.

Taxes paid:

U: $1,200; L: $720. Equity $ proportionally lower than NI.


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Now consider the fact that EBIT is not

known with certainty. What is theeffect of uncertainty on stockholder

profitability and risk for business U and

business L?

Continued


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Business U: Unleveraged

Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0

EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

EconomyBad Avg. Good


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Business L: Leveraged

Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800

Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for business U.

EconomyBad Avg. Good


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business U Bad Avg. Good

BEP 10.0% 15.0% 20.0%ROIC 6.0% 9.0% 12.0%ROE 6.0% 9.0% 12.0%

TIE n.a. n.a. n.a.business L Bad Avg. Good

BEP 10.0% 15.0% 20.0%ROIC 6.0% 9.0% 12.0%

ROE 4.8% 10.8% 16.8%TIE 1.7x 2.5x 3.3x


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Profitability Measures:

E(BEP) 15.0% 15.0%E(ROIC) 9.0% 9.0%

E(ROE) 9.0% 10.8%

Risk Measures:s

ROIC 2.12% 2.12%sROE 2.12% 4.24%

U L


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Conclusions Basic earning power (EBIT/TA) and ROIC

(NOPAT/Capital = EBIT(1-T)/TA) areunaffected by financial leverage.

L has higher expected ROE: tax savingsand smaller equity base.

L has much wider ROE swings because of

fixed interest charges. Higher expectedreturn is accompanied by higher risk.

(More...)


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In a stand-alone risk sense, businessLs stockholders see much more risk

than business Us. U and L: sROIC = 2.12%.

U: sROE = 2.12%.

L:s

ROE = 4.24%. Ls financial risk is sROE - sROIC =

4.24% - 2.12% = 2.12%. (Us is zero.)

(More...)

Conclusions


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nFor leverage to be positive (increaseexpected ROE), BEP must be > rd.

n If rd > BEP, the cost of leveraging willbe higher than the inherentprofitability of the assets, so the useof financial leverage will depress net

income and ROE.

n In the example, E(BEP) = 15% whileinterest rate = 12%, so leveraging

works.

Conclusions

capital structure basics

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